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Is the Sky Falling?

Written by Ethan S. Braid, CFA on 10 - 15 - 2014

 

Is the Sky Falling?

 

With the sell-off in the stock markets today, as of 1:30pm ET, the Dow Jones Industrial Average is down about 4% for the year and the S&P 500 is negative by about 1%.  People are starting to panic again.  Why?  To give investors some perspective on stock market returns, I put together the following data presentation and follow up with my market assessment.

The past five years brought tremendous gains as we dug out of the 2008 mortgage & housing bubble.  The S&P 500 returns over the last six years were:

  • 2013                32.39
  • 2012                16.00
  • 2011                2.11
  • 2010                15.06
  • 2009                26.46
  • 2008                (37.00)

 

Including today’s sell-off, an investment of $1,000,000 in the S&P 500 at the beginning of 2008, would today be worth:  $1,423,097.  Therefore, despite the 37% drop in 2008, a 42.30% cumulative total return has been achieved in the past 6 years and 9+ months.  Not too shabby!  

Looking at the last six years of returns we can see that the S&P 500 has experienced a fair amount of volatility.  The standard deviation on the above data set is approximately 25 for those six years.  From statistics we know that for a given population (think S&P 500 annual returns) and assuming a normal distribution, future numbers can be estimated to be within + or – 2 standard deviations from the mean (expected return) 95%  of the time.  Therefore if the mean return over time on the S&P 500 is approximately 9%, then:

  • Outlier positive return:            2sigma x 25stdev  + 9er          =          59%
  • Outlier negative return:           2sigma x -25stdev + 9er          =          (41)%

Looking at the last six years of returns from this perspective shows that we experienced a near worst-case scenario in 2008 and about 55% of a best-case scenario in 2013.  In fact, widening our lens and going back to 1970, we find that there have been only two years with negative returns in excess of -20% and only one year with a negative return over -30% (2008).  Large positive returns have occurred far more frequently with eight years of returns over 30%, the best year being 1995 at 37.58% total return.

Putting it all together, we can see that over the last four decades+, stocks tend to have more positive years than negative and also experience large positive returns over large negative returns by a factor of 2.6:1.  Stocks can lose money in any one year and that loss can be substantial, as much as -41% or more.  We should expect that 95% of the time returns will be within +59% and -41%.  Returns above 59% or below -41% can happen 5.00% of the time (i.e. once in a lifetime) and this experience is called a “tail event.” 

While rare, losses over 20% are not pleasant and do happen.  If an investor cannot emotionally handle this type of loss, she should not have 100% stock market exposure.  Instead, she should incorporate an asset allocation strategy that is designed to lower her loss potential to a number that she is comfortable with.

 

FORTUNE TELLERS OR INVESTORS?

 

Fifteen years+ of managing money has taught me a number of lessons.  Chief among them is that anyone who attempts to predict the future and trades their portfolio based on short-term market movements is not an investor.  Rather, she is merely betting on market movements.  Consistently getting those bets right is difficult to say the least and very few people are up to the task.  More often than not, investors make mistakes when trying to time the markets and end up losing money in the process.

Investing however is a far different story.  Investors focus on variables that they can control:

  • Strategy (asset allocation)
  • Price Paid (overvalued or undervalued assets?)
  • Concentration
  • Expenses

 

Investors also have the self-discipline to execute two of the most important mental exercises necessary to succeed over time:

 

  • Reminding themselves that short-term is not the same as long-term.
  • Knowing themselves and their true risk tolerance and not letting emotions sway them.

 

Many would-be investors fail to achieve satisfactory returns because they do not evaluate their investments under the appropriate time frame.  The most common mistake I see is comparing short-term (several years or less) results with a long-term (minimum 7 years) investment.  The stock market is an excellent example.  An investment in the stock market should be considered, in my opinion, to be a decade long commitment if one wants to succeed.  All too often however, the latest media induced crisis or stock market gyration scares investors to the point that they lose sight of the long-term nature of their investment and make short-sighted decisions. 

The other major mistake I see many investors make is the tendency to overestimate their own risk tolerance during a rising market.  Many times over my career I have met with investors who stated that they were aggressive or wanted to take on risk at a time when the market had been going up.  Once the market started to correct however, those same individuals became more risk-averse and questioned why they had so much in equities.  In contrast, successful investors  possess a high degree of self-discipline and know themselves well enough to not allow emotions to have an undue influence on their ongoing decisions.  Successful investors rely on their self-discipline to help them stick with the strategy they put in place and give their strategy the necessary time to perform for them.

 

WHAT DO YOU THINK OF THE MARKETS NOW AND WHAT SHOULD I DO?

 

Whenever the markets begin to sell, this question immediately comes up.  I get posed with this question in social settings, with clients and also with prospective clients.  What should I be doing people want to know?  Here is a summary of the steps one should take:

  • 1.  Revisit the process that let you to your investments and answer:
  • Was the process robust and thorough?
  • Is your portfolio in alignment with your true risk tolerance?
  • How was your portfolio constructed?
  • Why do you own the investments you own?
  • Do you know what to expect in terms of loss if things get ugly?
  • Are current losses anywhere near your downside threshold for pain?
  • Do the valuations of the assets classes you own seem reasonable?

If your financial planning and corresponding investment strategy development processes were diligent and done carefully, then the odds are that you probably should do very little right now.  Again, disciplined investors tend to trump market timers when it comes to wealth accumulation over time.

  • 2.Focus on what you can control.

Valuations matter when selecting asset classes for a portfolio strategy.  I find it is easier to pick the asset classes to avoid and then make decisions from there.  Today, we have the following data:

  • 10 year treasury yield:            2.00
  • S&P 500 yield:                        2.30
  • S&P 500 P/E:                          18.42
  • US Dollar Index:                     85
  • Gold:                                     $1,239/oz
  • WTI Crude Oil                        $81.50

At a 2.00% yield, avoiding treasuries is a no-brainer.  Unless deflation comes, this asset class is going to be a loser for a long time to come.  With yields so low, factoring in inflation and taxes means that you have a negative real return.  Corporate bonds and junk bonds yield scarcely more than treasuries and should also be avoided.  With interest rates at historic lows and little upside ahead, avoiding the bond market is a good idea.

The S&P 500 P/E ratio is slightly higher than the long term average of approximately 16.  Going back to the 1800s, readings over 20 indicate market tops and readings in the single digits demonstrate bottoms.  In the last 100 years, there have been four notable periods where P/Es over 20 signaled an overvalued market:

 

  • Early 1900s
  • Late 1920s
  • Mid 1960s
  • Late 1990s to mid 2000s

 

  • Bear markets eventually followed all of the above time periods

 

Extreme undervaluation for the S&P 500 was demonstrated by single digit P/Es at the following times in the last 100 years:

 

  • Early 1920s
  • 1932
  • 1942
  • Early 1980s

 

  • Bull markets took off in the years following the above time periods.

At the current P/E level, one could make the case that the stock market is likely fairly valued.  While a bear market could take place from here, a bull market could just as easily be experienced.  Therefore, sticking with stock investments will likely prove to be a good idea going forward. 

Another way to assess the markets is to consider that for money meant to be invested for the next 10 years, you get a 15% premium in yield on the S&P 500 when compared to the 10 year treasury.  And while your yield on the 10 year treasury is fixed at 2.00, your yield on the S&P 500 can increase if dividends are raised.  Historically, the stock market has been considered a good buy when the yield on the stock market exceeds the bond market (10 year treasury).  We are in that situation now.

The US Dollar Index is far, far below the high it hit of 165 in 1984.  The current reading of approximately 85 is also much lower than where the index was in 2000 when it was at 120.  Predicting future currency movements is not something I am particularly skilled at, but it does seem likely that the dollar’s major declines are in the past.  If the dollar continues to strengthen from here then one can expect more pain for commodities.  Also, a strengthening dollar will be detrimental to investors purchasing emerging markets (either equity or debt) or other international investments due to currency translation effects.  Finally, emerging markets GDP numbers are heavily concentrated in commodities and thus a decline in commodities would be bad news for emerging markets investors.  In recent years US oil production has soared.  There is a very real possibility that in the years ahead, the world finds itself awash with oil and prices drop precipitously.  Gold has had a tremendous run since the early 2000s and is also vulnerable to further losses.  If interest rates move up meaningfully or the dollar strengthens the gold market could get turned upside down.  At this point, I would avoid commodities as well as emerging markets.  Too much risk and not enough value.

 

About the author of this article.

Ethan S. Braid, CFA is the founder of HighPass Asset Management – an independent, fee-only, registered investment advisory firm with a fiduciary duty to the clients it serves.  Mr. Braid has been passionate about managing client investment portfolios and providing customized financial planning advice since he started working in the investment industry 15 years ago. Mr. Braid earned a BS in Finance from Robert Morris University, an MBA from Cleveland State University and he is also a CFA Charterholder.

Mr. Braid is devoted to being an expert in the field of wealth management for high net worth individuals and families and for many years, has read one book per month on subject areas such as:  estate planning, retirement planning, investment analysis, mergers & acquisitions and behavioural finance.  Mr Braid also has a passion for business history with a focus on the late 19th & early 20th centuries.

When Mr. Braid is not helping clients, he enjoys: cooking, wine, exercise, his yellow Labrador retriever, fly fishing, hiking, travel, playing guitar, snowboarding and duck hunting.  Mr. Braid is a committee member of the Denver Chapter of Ducks Unlimited.

This article is provided by HighPass Asset Management for informational purposes only.  No portion of this commentary is to be construed as a solicitation to buy or sell a security or the provision of personalized investment or legal advice.